Correlations Have Yet to Climb the Wall of Fear

Europe’s endless debt crisis has at times afforded us all a good look at what market panics look like in a post-Lehman world.

Nervous markets have always been highly correlated, but now they are more so than ever, and in more ways.

These days, when market stress rises, we can expect to see correlations increase markedly within asset classes, across them, and, crucially, between general investor risk appetite and the performance of widely disparate assets. The link between the euro/dollar pair, for example, and the S&P 500, was closer than it had ever been at the end of 2011.

Now it would seem to stretch credulity to suggest that investors could possibly be more relaxed at present than they were then. It’s becoming clearer that the torturous, imbalanced euro-zone equation may not actually have a solution, for one thing. Its latest twist is that German Chancellor Angela Merkel has reportedly ruled out the mutualization of euro-zone debt while she has breath in her body. Strong stuff.

Moreover, behind the euro zone’s immediate worries is the reality of slowing growth just about everywhere; with forecasts revised down from Beijing to New York via London.

And yet those cross-market correlations are it seems lower now than they were then.

“For now, we are on the edges of full contagion but the market doesn’t have the capital at risk to push on this point of instability,” wrote Sebastien Galy, senior currency strategist at Société Générale. “We can see this from the fact that cross-asset correlations are well off their peaks,” he added.

Similarly, the markets’ correlation with overarching investor risk appetite remains well below what it has been. It’s still high, make no mistake. It’s just not that high

“At the moment the Equity Risk On Risk Off Index is high by historical levels, albeit at much lower levels than the all-time highs seen in late 2011,” wrote analysts at HSBC, who publish it. “This indicates that movements in individual equities remain very similar but that signs of more dispersion have come through.”

So, despite all their worries, investors still aren’t lumping all stocks together as ‘risk assets,’ as they used to.

Here are phenomena that need explaining. Perhaps investors are simply more inured to bad news these days. After all, when Moody’s did its hatchet job on Spanish lenders earlier this week, the reaction was barely a shrug. Indeed, given their first chance to react, European stocks actually opened higher on Tuesday morning. And the euro? Well, its initial response was a yawn and a three-tick fall. Hardly seismic.

Or perhaps it might be that current levels of investor fear have yet to show up in the correlation data, which is of necessity backward looking.

However, the most likely reason is that, this time, investors are certain that the world’s central bankers will ride to the rescue with another tsunami of liquidity. Whatever caveats and hedges they offer in their public statements, the world thinks it’s coming.

If it’s delayed, or diluted, it must be likely that we’ll see those correlations back to where they were, at panic levels.